The IRS released final regulations (TD 9901
) on July 9 that ease documentation standards and provide greater flexibility for taxpayers claiming the deduction for foreign-derived intangible income (FDII).
IRC Section 250 was enacted by the Tax Cuts and Jobs Act (TCJA) to provide a deduction to corporate taxpayers for half of their global intangible low-taxed income (GILTI) and 37.5% of their FDII. The deduction is meant to help limit the role that tax consequences play when a domestic corporation chooses the location of its intangible income attributable to foreign markets. The regulations finalize rules under Sections 250, 962, 1502, 6038, and 6038A, providing guidance in a number of areas. They principally follow the structure of the proposed regulations but do make meaningful changes.
Key departures from the proposed rules include moving from specific documentation rules to more broad substantiation requirements, making changes to the “foreign use” standard for sales of general property that include an expansion of the manufacturing exception, and modifying the related party rules. The regulations also solidify the proposed rule that, for purposes of Section 962, allows an electing individual to claim the benefit of the Section 250 deduction to offset its GILTI and the Section 78 gross-up attributable to the shareholder’s GILTI, and also clarifies that a Section 962 election may be made on an amended return in certain instances.
Taxpayers previously affected by the burdensome documentation requirements under the proposed regulations should consider revisiting contracts and re-evaluating how the final regulations might positively impact their Section 250 documentation processes. Taxpayers should also take advantage of the delayed effective date of the final regulations, which provides additional time to implement the rules and to assess opportunities around the computation of the deductions.
The most impactful changes imposed by the final regulations are summarized below.
For tax years beginning after 2017, U.S. shareholders of controlled foreign corporations (CFCs) are subject to current U.S. tax on their GILTI inclusions under Section 951A. GILTI is generally defined as the excess of a U.S. shareholder’s aggregated “net tested income” from CFCs over a routine return on certain qualified tangible assets. The TCJA provides domestic corporations a 50% deduction of its GILTI amount (37.5% for tax years beginning after 2025). This deduction is provided under Section 250.
Section 250 also includes incentives to a domestic corporation to offset a portion of certain FDII earned by the domestic corporation. The provision allows for a deduction equal to 37.5% (21.875% for tax years beginning after 2025) of a domestic corporate taxpayer’s FDII. Both the FDII and GILTI deductions are subject to a taxable income limitation.
A domestic corporation’s FDII for a tax year is computed as follows:
A domestic corporation’s deduction-eligible income (DEI) is the excess of gross income over properly allocable deductions, including taxes. Certain amounts are excluded from gross income, including Subpart F income, GILTI, financial services income and foreign branch income. A domestic corporation’s foreign-derived deduction eligible income (FDDEI) for a tax year is any DEI that is derived in connection with:
- Property sold to any person who is not a U.S. person and that is for a foreign use
- Services provided to any person, or with respect to property, not located within the United States
A domestic corporation’s deemed intangible income (DII) for a tax year is the excess, if any, of its DEI over its deemed tangible income return (DTIR) for the year. A U.S. corporation’s deemed tangible income return is 10% of the corporation’s qualified business asset investment (QBAI). QBAI is a domestic corporation’s adjusted tax basis in depreciable tangible assets used in the production of DEI.
The new incentive is much broader than traditional intangible income. Foreign-derived intangible income is defined to include income received from the sale of property for foreign use or services rendered to persons outside of the United States (with special rules for transactions with related parties). The sale of property for foreign use also includes income from leasing and licensing, as well as income from other dispositions.
Relaxed rules for documentation
The proposed regulations imposed strict documentation requirements on domestic corporations that many observed to be unduly onerous. These rules provided that, among other things, documentation must be obtained by the FDII filing date (generally the extended due date of the income tax return on which the Section 250 deduction is claimed), no earlier than one year before the sale or service, and that the seller or provider must not know or have reason to know that the documentation is incorrect or unreliable. Beyond this, the rules included differing requirements depending on the type of transaction and provided finite lists of qualifying documentation required to support a FDII deduction.
The final regulations replace the documentation rules with a more flexible “substantiation” requirement. In doing so, they no longer require specific types of documents to establish:
- Foreign-person status
- Foreign use with respect to sales of certain general property that are made directly to end users
- The location of general services provided to consumers
The regulations do, however, include specific requirements for substantiating sales of general property to recipients other than end-users, sales of intangible property and general services provided to business recipients. The IRS contends that specific substantiation requirements for foreign use are needed in these situations to ensure that taxpayers make sufficient efforts to determine whether the requirement is met (e.g., transactions where the relevant facts needed to satisfy the rules are in the hands of a third party with a business relationship with the taxpayer).
For the rules in the regulations without specific substantiation requirements, the preamble notes that taxpayers are already required under Section 6001 to keep necessary records to support deductions claimed on its return. As a result, a taxpayer claiming a FDII deduction is still required to substantiate its entitlement to the deduction even when there are not specific substantiation requirements contained in the final regulations.
In general, the substantiation rules continue to require that substantiating documents be in existence by the FDII filing date. However, the final regulations do not impose additional requirements relating to when substantiating documents must be in existence. The regulations also retain, but modify, the “reason to know” standard. A taxpayer is considered to have a reason to know that a transaction fails to satisfy a substantive requirement if the information received as part of the sales process contains information that a requirement is not met, and after making reasonable efforts, the taxpayer cannot establish such requirement is met. The final regulations also provide that substantiating documents must be provided to the IRS upon request, generally within 30 days or some other period agreed upon by the IRS and the taxpayer.
Grant Thornton Insight: The proposed regulations’ requirement that documentation be obtained no earlier than one year before the sale or service occurred prevented the use of long-term contracts as creditable evidence in years after the contract was entered into. The removal of this requirement now allows long-term contracts to satisfy the new substantiation requirements for all years under contract, preventing the need for annual renewal of supporting documentation. However, the preamble notes that substantiating documents created when the transaction was entered into will be more credible in later years if the taxpayer periodically confirms that the terms of the long-term contract are being followed.
The final regulations include guidance as to the kinds of evidence taxpayers can obtain to fulfill the specific substantiation requirements that remain. For example, general property sold to recipients other than end-users have differing substantiation requirements depending on whether the general property is sold to foreign resellers or manufacturers. In the case of sales to resellers, a taxpayer must maintain credible evidence that the general property will ultimately be sold to end-users located outside the United States. This requirement is satisfied if the taxpayer maintains evidence of foreign use such as the following:
Grant Thornton Insight: The new substantiation requirements are generally more flexible than the proposed version. However, taxpayers should note that specific substantiation requirements are in place for certain transactions. Some of these requirements may present business challenges to taxpayers when attempting to obtain corroborating evidence. Thus, it is recommended that taxpayers perform a thorough review of their contract terms, arrangements and other information obtained during the sales process to ensure such substantiation requirements are satisfied.
- A binding contract that limits sales to outside of the United States
- Proof that property is specifically designed, labeled, or adapted for a foreign market
- Proof that the shipping costs would be prohibitively expensive if sold back to the United States
- Credible evidence obtained or created in the ordinary course of business from the recipient evidencing that property will be sold to an end-user outside the United States
- A written statement prepared by the seller containing certain prescribed information, including how the seller determined that property will be sold to an end-user outside of the United States
The regulations also expand the small business exception that exempts small taxpayers from certain substantiation requirements. The threshold was expanded from $10 million of gross receipts in the prior taxable year to $25 million in gross receipts received by the taxpayer and all related parties. However, the final regulations do not include exceptions for “small transactions” of less than $5,000, as provided in the proposed regulations, but do offer a similar rule for sales of digital content that are, in aggregate, less than $50,000 with respect to an end-user.
General property for a foreign use
Under the proposed regulations, sales of general property were considered to be for foreign use if either the property was not subject to domestic use within three years, or the property was subject to manufacture, assembly, or other processing outside of the United States before any domestic use of the property. These rules also provided that general property was subject to manufacturing, assembly or other processing only if it meets either of the following two tests: 1) there is a physical and material change to the property (material change test), or 2) the property is incorporated as a component into a second product (component part test).
The proposed regulations also indicated that the material change test did not include “minor assembly, packaging, or labeling,” and provided that general property is incorporated as a component into a second product under the component part test only if the fair market value of the property when it is delivered to the recipient constitutes no more than 20% of the fair market value of the second product.
The final regulations implement changes to provide a more flexible definition of foreign use of general property and eliminate the requirement that the taxpayer have no “reason to know” of some domestic use for sales of general property. The final regulations provide that the sale of general property is for foreign use if the property is subject to manufacturing, assembly or other processing outside the United States, or if delivered to an end-user outside the United States, but no longer requires that it not be subject to domestic use within three years. The rules also provide that a sale of rights to exploit intangible property solely outside the United States also is for a foreign use, and that a sale of rights to exploit intangible property worldwide is partially for a foreign use and partially not for a foreign use. A sale of rights to exploit intangible property solely within the United States is not for a foreign use.
The final regulations provide that a sale of general property that is delivered through a carrier or freight forwarder to an end-user is for a foreign use if the end-user receives delivery of the general property outside the United States. However, such sale is not treated as a sale to an end-user for a foreign use if the principal purpose of the sale is to transport the property from its location outside the United States to a location within the United States for ultimate use or consumption.
With respect to sales that are not delivered through the use of a carrier or freight forwarder, a sale of general property to a recipient that is an end-user is for a foreign use if the property is located outside the United States at the time of the sale (including as part of foreign retail sales).
A sale of general property for resale is for a foreign use if the general property will ultimately be sold to end-users outside the United States and such sales substantiated.
Expansion of the manufacturing exception
With regard to manufacturing, the final regulations retain the two tests from the proposed regulations but revise the manufacturing exception in several key ways, including:
- Clarifying that general property is subject to the material change test if it is “substantially transformed and is distinguishable from and cannot be readily returned to its original state”
- Providing a separate “substantive rule” for the component part test
- Retaining the 20% threshold in the component part test, but only as a safe harbor
- Revising the safe harbor in the component part test by specifying that the comparison should be between the fair market value of the property sold by the taxpayer and the fair market value of the final finished goods sold to consumers
- Providing that, as part of the component part test, a reliable estimate of the fair market value of the finished good could include the average fair market value of a representative range of the finished goods that could incorporate the component part
Under the new substantive rule added to the component part test, general property is a component incorporated into another product if the incorporation of the general property into another product involves “activities that are substantial in nature and generally considered to constitute the manufacture, assembly, or other processing of property based on all the relevant facts and circumstances.”
Grant Thornton Insight: The addition of a facts and circumstances based substantive rule is a welcome change to the component part test. Under the proposed regulations, the 20% threshold in the component part test often prevented high-value component parts from being treated as manufactured outside of the United States even when the product underwent substantial manufacturing and was incorporated in a finished good that was dissimilar to the component part (e.g., chips incorporated into tablets or computers). The final regulations include an example illustrating this where a high-value part (batteries) is treated as for foreign use when the manufacturing activities to incorporate the battery into tablets is substantial in nature.
The final regulations also provide an additional rule for the sale of general property that includes digital content. The term digital content is defined in the final regulations as a computer program or any other content in digital format. Specifically, the final regulations provide that a sale of general property that primarily contains digital content that is transferred electronically rather than in a physical medium is for a foreign use if the end-user downloads, installs, receives, or accesses the purchased digital content on the end-user’s device outside the United States. In the event that information about where the digital content is downloaded, installed, received, or accessed (such as the device’s IP address) is unavailable, and the aggregate gross receipts from all sales with respect to the end user are less than $50,000, the final regulations provide that a sale of general property is for a foreign use if the end-user that has a billing address located outside the United States.
Foreign person status
In general, the proposed regulations provided that to establish that a recipient is a foreign person, the taxpayer needed to obtain specific types of documentation. Specifically, the taxpayer needed to obtain a written statement by the recipient, documentation establishing the entity is organized under the laws of the foreign jurisdiction, a valid identification issued by a foreign government or agency (in the case of an individual) and document filed with a government agency that provides jurisdiction of an entity. The final regulations remove the specific documentation requirements to establish foreign person status and foreign use with respect to certain sales of general property and the location of a consumer of a general service.
In lieu of the documentation requirements, the final regulations provide a broad presumptive rule for determining foreign person status. However, the presumptive rule does not apply if the seller knows or has “reason to know” that the sale is not to a foreign person. The final regulations indicate that a person has reason to know if the information received as part of the sales process contains information that indicates that the recipient is not a foreign person and the seller fails to obtain evidence establishing that the recipient is, in fact, a foreign person.
Modifications to related party rules
The proposed regulations provide specific rules for determining whether a sale of property or a provision of a service to a related party is a qualifying FDDEI transaction. Under these rules, related-party transactions must meet additional requirements, beyond the general requirements, in order to be treated as a qualifying FDDEI transaction. The final regulations generally retain these related-party rules, but with certain modifications.
The final regulations modify the resale requirement to allow a taxpayer to treat a sale to a related party as a FDDEI transaction in the tax year of the related-party sale provided that an unrelated-party transaction has occurred or will occur in the ordinary course of business with respect to the property sold to the related party. This is in contrast with the proposed regulations, which required an unrelated-party transaction to occur before the taxpayer can treat the original sale to the related party as a FDDEI transaction. This change prevents the need for amended returns for taxpayers with longer sales cycles.
The final regulations made several other tweaks to the proposed rules. For example, the final regulations remove the requirement that the FDII filing date is determinative with respect to related-party sales and use of property in an unrelated-party transaction, they include guidance on how a taxpayer can demonstrate that an unrelated-party sale will later occur and modify the intermediaries rule to include certain related U.S. persons.
Taxable income limit rules
The Section 250 deduction is subject to a limitation based on the taxable income of the taxpayer. If a domestic corporation’s GILTI and FDII exceed its taxable income, the excess is allocated pro rata to reduce these amounts for purposes of computing the Section 250 deduction. The proposed regulations provided that a domestic corporation’s taxable income for purposes of applying the taxable income limitation of Section 250(a)(2) is determined after all of the corporation’s other deductions are taken into account. Additionally, a five-step process was outlined in the preamble to the proposed regulations for purposes of determining taxable income when computing the limitation of the deduction under Section 250, where ordering was necessary to coordinate Sections 163(j), 172 and 250.
Following comments received by taxpayers, the IRS determined that additional study is needed to determine the appropriate methodology for coordinating Sections 250(a)(2), 163(j), 172 and others. Accordingly, the final regulations remove the example of the ordering rule that was contained in the proposed regulations and the IRS reserves in the final regulations for coordinating Section 250(a)(2) with other provisions with limitations calculated based on taxable income. Before further guidance is issued regarding how allowed deductions are taken into account in determining the taxable income limitation in Section 250(a)(2), taxpayers may choose any reasonable method if the method is consistently applied for all taxable years beginning on or after Jan. 1, 2021.
Grant Thornton Insight: The reservation on the ordering rules is a major development that will provide temporary flexibility for taxpayers. The IRS indicated they are considering a separate guidance project to coordinate Sections 250(a)(2), 163(j) and 172. Presumably, forthcoming final regulations under Section 163(j) will reflect this decision.
Foreign branch income definition
The final regulations modify the definition of “foreign branch income” contained in the proposed regulations. As a general matter, the modification appears to narrow the scope of what constitutes foreign branch income for purposes of Section 250 and may be taxpayer favorable.
By way of background, the statutory language of Section 250(b)(3) excludes certain categories of gross income when determining deduction eligible income for FDII purposes, including foreign branch income. The statute defined foreign branch income for purposes of the exclusion using Section 904(d)(2)(J) with modification to also include any income from the sale, directly or indirectly, of any asset that produces gross income attributable to a foreign branch, including by reason of the sale of a disregarded entity or partnership interest. In effect, the modified definition of foreign branch income in the proposed regulations created a disconnect in what constituted foreign branch income for purposes of Sections 904 and 250.
In the final regulations, the IRS agreed that there should be one consistent definition of foreign branch income. Accordingly, the final regulations define foreign branch income by cross refence to Treas. Reg. Sec. 1.904-4(f)(2) without modification. As a result, income from the sale of certain assets that produce foreign branch income will generally not be considered foreign branch income and, therefore, may not be excluded from the scope of deduction eligible income for FDII.
Section 962 elections
Final regulations issued under Section 962 retain taxpayer favorable rules from the proposed regulations. Section 962 provides that an electing individual may determine their tax liability on certain income by applying the corporate tax rates and taking into account certain foreign tax credits. Section 962 aims to allow individuals to achieve a tax result similar to that which would result from the imposition of a domestic corporation to own certain foreign stock as opposed the individual owning the foreign stock directly. Section 962 applies to income inclusions under Section 951(a). Further, under prior regulatory guidance, GILTI income, or income included by reason of Section 951A, qualifies for Section 962 treatment in the hands of an electing taxpayer.
The proposed and final regulations under Section 250 provide that an electing individual is permitted to claim a Section 250 deduction against their GILTI inclusion. Individuals not electing Section 962 generally would not qualify for a Section 250 deduction because the deduction is statutorily limited to domestic corporations.
Separately, the preamble to the final regulation addresses uncertainty regarding the situations in which individuals may make a Section 962 election on an amended return. While stating that further guidance is under consideration for Section 962 elections, the preamble provides that individuals may make an otherwise valid Section 962 election on an amended return for the 2018 tax and subsequent years regardless of circumstances, provided the interests of the government are not prejudiced by the delay. This apparently alleviates concerns around whether elections would be permitted on amended returns, pending further guidance.
Taxpayers are afforded flexibility with respect to the application of final regulations. Generally, the final rules under Section 250 apply to taxable years beginning on or after Jan. 1, 2021. However, taxpayers may choose to apply the final or proposed regulations for taxable years beginning before Jan. 1, 2021, provided they are applied in their entirety. Taxpayers that choose to rely on the proposed regulations may apply the proposed transition rules for documentation to tax years beginning before Jan. 1, 2021, provided that the proposed regulations are applied to such years. The proposed transition rule included relaxed documentation standards that allowed for the use of any reasonable documentation collected in the ordinary course.
While the final regulations maintain the basic approach and structure of the proposed regulations, they make a number of favorable changes especially with regard to the documentation requirements for taxpayers. The final regulations relax many of the strict documentation requirements previously imposed under the proposed regulations and offer greater flexibility to taxpayers as to how they substantiate their FDII deduction. Taxpayers who previously were subject to burdensome documentation requirements under the proposed regulations should consider revisiting contracts and re-evaluating how the final regulations might positively impact their Section 250 documentation processes. Additionally, the delayed effective date of the final regulations provide taxpayers time to implement the rules and to assess opportunities around the computation of the deductions.
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